According to a blog post in the New York Times from April 2009, America’s America’s “progressive” tax system is not as progressive as many may believe it to be:

Research has found that many states and local governments have… regressive tax systems… that might offset the progressiveness of [US] federal tax rates.

The research from Citizens for Tax Justice — a liberal organization that advocates “fair taxes for middle and low-income families” — uses 2008 data for all federal, state and local taxes combined. It found that the average effective tax rate is 29.8 percent, and that including state and local taxes makes the tax curve look much less steep:

In the graph above, the horizontal axis shows the income group. The vertical axis shows the percentage of income that the average member of that group pays in taxes. Taxes include all federal, state and local taxes (personal and corporate income, payroll, property, sales, excise, estate, etc.). Incomes include cash income, employer-paid FICA taxes and corporate profits net of taxable dividends.

The article continues:

The group also finds that in 2008 the share of total federal, state and local taxes paid by each income group was relatively close to the share of income that that group brings in, at least as compared to comparable 2006 numbers for effective federal tax rates:

The horizontal axis shows the income group. Taxes include all federal, state and local taxes (personal and corporate income, payroll, property, sales, excise, estate, etc.). Incomes include cash income, employer-paid FICA taxes and corporate profits net of taxable dividends.

The research discussed above poses several interesting questions about the make-up of a nation’s tax revenues. Despite popular belief, it appears that the rich in America do not pay “more than their fair share”, as many argue is the case. Study the graphs carefully, and answer the questions that follow:

Discussion Questions:

Based on the data above, do the rich in America pay an unfair proportion of the total taxes the US government collects? Why or why not?

Why do the richest 5% in America actually pay a lower level of tax on average than the 5% below them?

How much of America’s total income is earned by the richest 1% compared to the poorest 20%? Does America’s progressive tax system destroy the incentive for Americans to work hard and become rich? Why or why not?

Use the data to construct a Lorenz Curve for the United States. Does the gap between the richest and the poorest Americans surprise you? What kinds of changes could be made to the tax system to narrow the gap between the top income earners and the middle and low income earners in America? Should this be done, why or why not?

So when a government makes a bold move that is economically sound, it sometimes comes as a surprise, as in the case of the Malaysian government this week. The government in Kuala Lumpur has for years subsidized domestic fuel prices, which at under 2 Malaysian Ringit per liter have been the equivelant of roughly $2.40 US per gallon, far below the average price in the west. Drivers benefited from this subsidy, but were not forced to bear any of the burden of rising oil prices, nor had they any incentive to conserve or switch to more fuel efficient automobiles or alternative forms of transportation. The Malaysian government, on the other hand, has had to allocate more and more of its limited budget towards subsidizing petrol prices.

Well, as of yesterday, all price supports for petrol are cancelled, and the effect will be sweeping in the Malaysian economy:

The government announced Wednesday evening that petrol prices would rise by 78 sen (US24¢) at midnight — a 41 percent jump from RM1.92 per liter to RM2.70. That means those spending RM2,000 per month to fill the tanks of their BMWs will now be paying RM2,820. Regardless of income levels, it is likely most Malaysians will feel the pinch.

The subsidy would have cost the Malaysian government 56 billion ringit (around $17 billion) this year. With the money it will now save by ending the subsidy, the government will begin making public transport cheaper and more convenient for commuters who wish to avoid paying for the more expensive petrol to fuel their personal automobiles:

The government hopes to channel the savings into improving public transportation, as it promised many years and elections ago but with little to show. In Kuala Lumpur, despite having a light rail train service and monorail, public transportation is expensive and inconvenient. Worse, intercity travel is still being serviced by old and slow trains, and accident-prone buses.

Malaysia is not the only country taking measures to end government fuel-price supports:

Indonesia has hiked fuel prices by an average of 29 percent, saving about 34.5 trillion rupiah and kicking off a series of street demonstrations… Similarly, after slashing subsidies, Taiwan will distribute US$659 million to middle and low-income families. The latest to raise oil prices is India, whose government announced Wednesday that gasoline and diesel prices will increase by 10 percent.

As more and more countries allow the market mechanism to work, and in the short-run fuel prices rise with the price of oil, the chances are that the long-run equilibrium price of petrol will actually begin to fall.Price controls and subsidies distort market demand. In Malaysia, where a government subsidy kept the price consumers paid around 2 RM, the quantity demanded exceeded the free market quantity. With the removal of the subsidy, consumers will respond by driving less, reducing overall quantity demanded for petrol. As other Asian nations follow suit, global quantity demanded for petrol will decline, while higher prices incentivize producers to increase output. New prouction facilities will come online, just as drivers begin to find alternative ways to get to work, either through carpooling, public transportation, cycling or walking.

The combined effect of slowing increases in demand (or perhaps even a decline in demand if enough substitution of alternative forms of transportation takes place), and increases in supply as new production facilities come on line will be a stabilization and eventual fall in the price of oil.

The future fall in oil prices is explained in more detail here. Malaysia’s repealing of the fuel subsidy is one example of how markets work to restore equilibrium in a market such as that for oil today, where short-term bubbles always burst. $135 oil is probably not here to stay, if only the market is allowed to works its magic.

The following was published in the Chicago Tribune’s “Voice of the People” page on October 29, 2008 in the midst of the US presidential race:

Redistributing wealth
On my way to lunch recently, I passed a homeless guy with a sign that read “Vote Obama; I need the money.” I laughed. In a restaurant my server had on an “Obama 08″ tie. Again I laughed. Just imagine the coincidence. When the bill came, I decided not to tip the server and explained to him that I was exploring the Barack-Obama-redistribution-of-wealth concept. He stood there in disbelief while I told him that I was going to redistribute his tip to someone who I deemed more in need—the homeless guy outside. The server angrily stormed from my sight. I went outside, gave the homeless guy $10 and told him to thank the server inside as I’ve decided he could use the money more. The homeless guy was grateful. At the end of my rather unscientific redistribution experiment, I realized the homeless guy was grateful for the money he did not earn, but the waiter was pretty angry that I gave away the money he did earn even though the actual recipient deserved money more. I guess redistribution of wealth is an easier thing to swallow in concept than in practical application.

—A. Hart, Forest Park

The comment reflects a general contempt for the concept of taxation, specifically progressive taxes, or those that tax high income earners at a higher rate than those who earn low incomes. The idea behind a progressive tax, of course, is that higher income earners have income left over after they have provided themselves with the necessities of life, therefore should bear a larger burden of the nation’s tax revenue, which thereby enables the government to “re-distribute” wealth from the nation’s higher income earners across all levels of society through the provision of public goods.

The federal income tax in the United States is progressive in that the higher one’s income, the higher the percentage he or she pays to the US government. As seen in the table below, America’s poor will pay as little as 0-10% in income tax, while the nation’s richest households can pay up to 35%.

Opponents of progressive income taxes, which are also known as direct taxes because they are taken directly from a person’s income, argue that such a tax system creates a disincentive to work among American households. They argue that progressive income taxes penalize hard work and innovation, since the higher a worker’s productivity, the more of his income he must relinquish to the government.

One commonly misunderstood fact about the US income tax, however, is that it is a marginal tax system, meaning that when a person goes from, say the 25% to the 28% bracket, he does not pay 28% on ALL of his income, only on the marginal income above $82,250 (according to the 2009 column above). The implication is, therefore, that the average tax paid by an American will at any level of income be lower than the marginal tax. Below is a graphical representation of this concept. [source: http://aufrecht.org/pictures/images/858554/tax400.png]

It is the re-distributive intentions and effect of a progressive income tax system such as America’s (and every other country, click here to see tax rates from around the world) that has led to such intense opposition to the US tax system. Many in America’s government have proposed a “fair tax” that does away with America’s current direct tax system in favor of a nation-wide indirect, or sales tax on most goods and services. Watch the video below:

The fair tax is a indirect tax, meaning it is levied not directly on peoples’ income but indirectly on the purchase of goods and services in the economy, and is described as follows:

The sales tax rate, as defined in the legislation, is 23 percent of the total payment including the tax ($23 of every $100 spent in total—calculated similar to income taxes). This would be equivalent to a 30 percent traditional U.S. sales tax ($23 on top of every $77 spent before taxes).[4] The effective tax rate for any household would be variable due to the fixed monthly tax rebates that are used to “untax” purchases up to the poverty level.[3] The tax would be levied on all U.S. retail sales for personal consumption on new goods and services.

The two guests argue that the fair tax “is the only tax that totally untaxes the poor; the poor get a free ride totally across the board at the federal level under this plan.”

However, a national sales tax is a “regressive tax” meaning that as a percentage of income, the fair tax places a larger burden on lower income earners than higher income earners. An example is useful:

Two shoppers walk into a computer store. One earns $50,000 a year, the other $100,000 a year.

Both are looking at a computer that costs $2,000. Under the fair tax, $460 of the purchase price of this computer will go to the government as tax.

$460 represents .92% of the income of the shopper who earns $50,000 per year.

$460 represents .46% of the incomeof the shopper who earns $100,000 per year.

The higher income earner pays a lower percentage of his income to the government in tax than the low income earner, making this a regressive tax.

One of the four macroeconomic goals governments aim to achieve in their policy making is more equal distribution of income. The fair tax, despite the arguments its advocates make, does not achieve a more equal distribution of income in America. It does place a smaller tax burden on the rich than the current system, but on the other hand America’s lower income earners bear a relatively larger burden of tax.

Discussion Questions:

Are taxes necessary? Why? What are some of the “public goods” tax revenues are used to provide in America and your country?

Does the Economy Self-Correct? – Welker’s Wikinomics PageThe debate in Washington over Obama’s fiscal stimulus package, which has now been re-written by both the House and the Senate, is ultimately one of the validity of orthodox economic theories. By voting for a nearly $1 trillion government spending bill, the Obama administration and Congress are clearly taking the position that an economy in recession will either not be able to correct itself, or will take too long to self-correct, thus the government is needed to accellerate the recovery process.

Washington’s stimulus package presents students and teachers of economics with an all too rare opportunity to put to the test the two competing hypotheses of macroeconomics: the Demand-side Theory versus the Supply-side Theory.

At the core of the long-running macroeconomic debate is the simple question, “Does the economy self-correct in times of recession?” The supply-side theory, attributed to the “classical” economists dating back to Adam Smith and David Ricardo, argues that the answer to this question is YES. The rationale between this laissez faire approach to macroeconomics is the following:

Falling demand in an economy means less output by firms, forcing them to lay off workers.

As inventories build up due to their inability to sell their output, firms will be forced to lower their prices, putting downward pressure on the price level in the economy (deflation).

High unemployment and falling prices eventually lead to workers in the economy being willing to accept lower wages.

Weak demand for commodities such as oil and minerals put downward pressure on raw material and energy prices faced by firms.

Falling wages and raw material prices mean more potential for profits for firms in various enterprises, even as overall demand in the economy is weak. Firms begin hiring workers at lower wages, and increase production to take advantage of lower input costs. Overall supply of goods and services in the economy begins to increase due to lower costs faced by firms in all sectors.

The downward spiral caused by weak aggregate demand, rising unemployment, falling prices for output, falling wages and commodity prices, is eventually reversed and turns into an upward spiral as firms hire more workers, employ more resources, creating more income and spending, moving the economy towards recovery and economic growth.

The supply-side theory of self-correction (so called because recovery results due to an outward shift of aggregate supply) outlined above depends on the downward flexibility of wages. If wages do NOT fall, as some demand-siders propose, then the idea that firms will eventually begin to hire more workers is busted, and unemployment will only continue to increase as overall demand remains weak.

Today, there is some evidence that wages in the United States may in fact be downwardly flexible.

…the base pay of higher-level U.S. executives will be lowered by 10 percent, while other salaried employees will face cuts of between 3 and 7 percent.

General Motors employees are beginning to accept lower wages. Rising unemployment, especially in the white collar sector, mean that the number of highly educated and skilled American workers unable to find work will grow as corporate layoffs continue.

A “shovel-ready” stimulus package from Washington may indeed help to “create or save” 3 million jobs, as Obama claims, but it is the self-correcting nature of markets due to flexible commodity prices and wages that will ultimately contribute to a recovery of the US economy. As prices of commodities fall, combined with lower wages for white collar workers and deflation in the overall economy, firms will find it profitable to begin employing resources at their lower costs, putting people back to work, stimulating spending through market forces.

Fiscal stimulus may accellerate the recovery process, but the threat it poses is the same threat posed by all forms of government intervention in the free market: that the nearly trillion dollars will go towards satisfying the priorities of politicians rather than the wants and needs of society as a whole, resulting in a misallocation of the nation’s resources towards goods, services, and infrastructure projects that are chosen by legislators, not the market itself. Stimulus is needed, but only the right kind. The recognition by politicians and the media that markets may also self-correct is also needed. News like GM’s wage cuts may sound dire, but the underlying implication of falling wages may be a sign that the US economy is already on the path to recovery, even before Washington has spent a single dollar on stimlus.

This week the CEOs of the “Big Three” US auto makers boarded their private jets in Detroit and touched down in Washington to beg and plead in front of Congress for a “low-interest bridge loan” from the US government to help them avoid bankruptcy. They are asking Congress for $25 billion of taxpayer money to give them the chance to re-structure and re-equip themselves for the future.

Below are eight arguments based on basic economic principles for why a bailout of the United States automobile industry is a bad idea and is bound to fail:

Incentives matter:A bailout of the US auto industry ignores the basic economic principle that incentives matter. Individuals and firms respond to incentives, pursuing behavior that is likely to bring them the greatest rewards. In the face of falling demand for their product and ever-increasing competition from more efficient foreign producers, providing a $25 billion bailout creates a disincentive to drastically reduce costs and increase competitiveness, and an incentive to continue using tired old techniques and providing the same old models for which demand has declined among Americans for over a decade.

Efficient allocation of resources:The United Auto Workers Union has a member ship of over 400,000 workers. Since the 1970s the union has lost over 1 million workers. Clearly the US auto industry has been in decline for decades, a fact that should be taken as a sign: resources employed in America’s car industry are inefficient and represent a over-allocation of resources. A drastic down-sizing of the auto industry, while resulting in short-run hardships for the hundreds of thousands whose jobs will be lost, will in the long run strengthen the US economy as labor and other resources will be freed up to be employed in sectors in which the US has comparative advantage.

Economic Darwinism or “the survival of the most efficient”:America has stood for free trade in the world since helping found GATT in 1948 and later the WTO. The gains from embracing free trade are shared among all stakeholders in the economy. Consumers enjoy lower prices (thus higher real income), firms enjoy access to cheaper inputs and larger markets for their products, and governments enjoy the increased tax revenues from rising incomes driven by export-led economic growth. To bail out an uncompetitive, inefficient, and long-declining industry is to spit in the eye of free trade and denies America any moral suasion it may hold in the future over potential trading nations in our attempt to open their markets to our nation’s products. To protect our own dying industry now will send a clear message to our trading partners. “America does NOT stand for free trade”. If we believe in free trade and the allocative power of markets, then we must let the dinosaurs of American industry meet the fate the natural selection of the marketplace has determined for it.

The benefits enjoyed by the few represent costs born by the many: A bailout by the US government of the auto industry will protect a few hundred thousand jobs for a few years at the most but spells a reduction in the disposable incomes and spending power of millions for years to come. The US does not have $25 billion laying around to give the Big Three, which means the money must be borrowed. Increased government borrowing raises interest rates now (further tightening the credit markets) and will result in increased taxes down the road. All government debt must eventually be paid off, and in the immediate future interest on this debt must be paid directly from tax revenue. A $25 billion bailout is the same as a subsidy, meaning it redistributes income and welfare from consumers to producers. Millions are asked to sacrifice for the continued survival of a few hundred thousand in an industry that has failed to evolve in a global auto market that has seen increased competition and efficiency from foreign firms for decades.

Moral hazard: Bailing out the Big Three today represent a classic case of moral hazard. When American industries fail to take steps to increase their efficiency and remain competitive in the face of increased global competition, they find themselves not surprisingly on the brink of collapse. To reward these firms by taking money out of Americans’ pockets and handing it to them to do as they will, we send the wrong message and create the wrong incentives in the American economy. The message is: “Don’t worry, the market doesn’t choose the winners and losers in the economy, the government does, and certain industries are too big to fail”.

Market failure, or Firm Failure?: The fate of the auto industry is in the hands of the US government. But so is the fate of the free market. My fear now is that the pendulum will swing too far to the left in America’s state of panic over the ill-fated downfall of the financial markets, rooted in the irrational exuberance and over-leveraging of big financial institutions. The failure of the financial markets, however, is an entirely different story from that of a dinosaur industry like automobiles. The Big Three have had decades to reform themselves, lower their costs, improve their products, and remain competitive. THEY have failed, NOT the market. Government intervention is necessary in instances of market failure, but NOT IN CASES OF FIRMS’ FAILURE TO COMPETE IN A WELL FUNCTIONING MARKET like the global auto industry.

Inflexible labor markets: I saw the president of the UAW on the news today giving 101 reasons why the government should approve a bailout deal for the Big Three. In fact, the unions that supposedly represent American Auto Workers are a big part of the problem the industry is facing. For decades the UAW has fought against wage and benefit cuts for auto workers, lobbying instead for higher tariffs and other barriers aimed at keeping foreign cars out of the country. This anti-competitive behavior is a major reason the Big Three cannot compete with European and Asian car makers today. Wage inflexibility leads to higher unemployment. Unions keep wages from going down, leaving the Big Three with one of two choices: Drastically downsize your workforce and employ fewer high paid auto workers, or beg the government for a multi-billion dollar subsidy to that the unions can be placated and you can survive for a couple more years until you’re in the same situation all over again. The unions helped cause the problem, now they should pay the price by experiencing the downsizing their demands inevitably foretold.

The US government should allow the free market to function and let the dinosaurs go extinct. Cars will still be made in America, they’ll just be made by the better, more efficient firms that emerge from bankruptcy when this is all over, as well as the numerous foreign firms already making cars in the US. Survival of the most efficient, that’s what markets are all about. Allowing the market to work will strengthen the US auto industry far more than a “short-term low-interest bridge loan” ever will, it will free up labor and capital resources to be employed by industries the country is better at, and make sure household income is NOT reallocated to inefficient firms to be squandered on the manufacture of a product for which demand has steadily declined for the last decade plus.